Final Topic Comp. Equilibrium

Chapter 11
Competitive Equilibrium
in an Exchange Economy
Exchange
Two consumers, A and B.
Their endowments of goods 1 and 2
are A A A
ω = (ω 1 , ω 2 ) and ω = (ω 1 , ω 2 ).
B B B
A
E.g. ω = ( 6,4 ) and ω = ( 2, 2 ).
B
The total quantities available

A B
are ω 1 + ω 1 = 6 + 2 = 8 units of good 1
A B
and ω2 + ω2 = 4 + 2 = 6 units of good 2.
Exchange
Edgeworth and Bowley devised a

diagram, called an Edgeworth box, to
show all possible allocations of the
available quantities of goods 1 and 2
between the two consumers.
Starting an Edgeworth Box
A B
ω
Width = 1 + ω 1 = 6+2= 8
Height =
A B
ω2 + ω2
= 4+2
=6
A B
ω
Width = 1 + ω 1 = 6+2= 8
Height =
A B The dimensions of
ω2 + ω2 the box are the
= 4+2 quantities available
=6 of the goods.
A B
ω
Width = 1 + ω 1 = 6+2= 8
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
One feasible allocation: the
endowment allocation.
The Endowment Allocation
OB
6
4
OA A
ω = ( 6,4 )
6
8
2
OB
2
6
4
OA
6 B
ω = ( 2, 2 )
8
2
OB
2
6 The
4 endowment
allocation
OA A
ω = ( 6,4 )
6 B
ω = ( 2, 2 )
8
More generally, …
Other Feasible Allocations
A A
( x1 , x 2 ) denotes an allocation to
consumer A.
B B
( x1 , x 2 ) denotes an allocation to
consumer B.
An allocation is feasible if and only if
x1A + xB1 ≤ ω 1
A
+ ω B
1
A B A B
and x 2 + x 2 ≤ ω 2 + ω 2 .
Feasible Reallocations
B
x1
OB
A
ω2 xB
2
+
B
ω2
A
x2
OA
x1A
A B
ω1 + ω1
B
x1
OB
A B
ω2 x2
+
B
ω2 A
x2
OA
x1A
A B
ω1 + ω1
Allpoints in the box, including the

boundary, represent feasible
allocations of the combined
endowments.
All points in the box, including the

boundary, represent feasible
allocations of the combined
endowments.
Which allocations will be blocked by
one or both consumers?
Which allocations make both
consumers better off?
Adding Preferences to the Box
xA For consumer A.
2
A
ω2
OA
ω 1A x1A
xA For consumer A.
2 M
or
e
pr
ef
er
re
d
A
ω2
OA
ω 1A x1A
xB For consumer B.
2
B
ω2
OB
ω 1B xB
1
xB For consumer B.
2 M
or
e
pr
ef
er
B re
ω2 d
OB
ω 1B xB
1
B
xB For consumer B. ω 1 OB
1
M B
ω2
or
e
pr
ef
er
r ed
xB
2
xA For consumer A.
2
A
ω2
OA
ω 1A x1A
A
Edgeworth’s Box
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Pareto-Improvement
DEFINITION: An allocation is Pareto-

improving if it improves the welfare
of a consumer without reducing the
welfare of another.
Where are the Pareto-improving

allocations?
A
Edgeworth’s Box
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
Pareto-Improvements
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving allocations xB
2
Pareto-Improvements
Since each consumer can refuse to

trade, the only possible outcomes
from exchange are Pareto-improving
allocations.
But which particular Pareto-
improving allocation will be the
outcome of trade?
A
Pareto-Improvements
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving reallocations xB
2
Pareto-Improvements
Pareto-Improvements
Pareto-Improvements
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Further trade cannot improve
both A and B’s
welfares.
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
B is strictly better Both A

off but A is strictly and B are
worse off worse
off
Pareto-Optimality
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
An allocation where convex
indifference curves are “only
just back-to-back” is
Pareto-optimal.
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
Where are all of the Pareto-optimal

allocations of the endowment?
A
Pareto-Optimality
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Pareto-Optimality
DEFINITION: The contract curve is

the set of all Pareto-optimal
allocations.
A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
The contract curve
xB
2
Pareto-Optimality
But to which of the many allocations

on the contract curve will consumers
trade?
That depends upon how trade is
conducted.
In perfectly competitive markets? By
one-on-one bargaining?
A
The Core
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving reallocations xB
2
A
The Core
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
The Core
x 2 Pareto-optimal trades blocked
by B
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
Pareto-optimal trades blocked
by A xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B are the core.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
The Core
DEFINITION: The core is the set of all
Pareto-optimal allocations that are
welfare-improving for both consumers
relative to their own endowments.
Rationaltrade should achieve a core

allocation.
The Core
Butwhich core allocation?

Again, that depends upon the
manner in which trade is conducted.
Trade in Competitive Markets
Considertrade in perfectly
competitive markets.
Eachconsumer is a price-taker trying

to maximize her own utility given p1,
p2 and her own endowment. That is,
...
xA For consumer A.
2
p1x1A + p 2x A
2 = p ω
1 1
A
+ p ω
2 2
A
A’s income
*A
x2
A
ω2
OA
x*1A ω 1A x1A
So given p1 and p2, consumer A’s net

demands for commodities 1 and 2
are
*A A *A A
x1 − ω 1 and x 2 − ω 2 .
And, similarly, for consumer B …

xB For consumer B.
2
B B B B
p1x 1 + p 2x 2 = p1ω 1 + p 2ω 2
B
ω2
x*2B
OB
ω 1B x*1B xB
1
So given p1 and p2, consumer B’s net

demands for commodities 1 and 2
are
*B B *B B
x1 − ω 1 and x 2 − ω 2 .
A Walrasian equilibrium is a vector

(x, p) such that for each consumer:
1) X is an optimal bundle
2) X is affordable
3) Markets clear
Trade
A
in Competitive Markets
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
x2 Can this PO allocation be
achieved?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
x 2 Budget constraint for consumer A
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
B
xB ω1 OB
1
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
xB
2
Trade
A
x2
B
xB ω1 OB
1
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
B
x
Budget constraint for consumer B 2
Trade
A
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
B
x
Budget constraint for consumer B 2
Trade
A
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
But *A *B A B
x1 + x1 < ω1 + ω1 xB
2
Trade
A
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
and *A *B A B
x2 + x2 > ω2 + ω2 xB
2
So at the given prices p1 and p2 there

is an
– excess supply of commodity 1
– excess demand for commodity 2.
Neither market clears so the prices
p1 and p2 do not cause a general
equilibrium.
Trade
A
x2 So this PO allocation cannot be
achieved by competitive trading.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
x2 Which PO allocations can be
achieved by competitive trading?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Since there is an excess demand for

commodity 2, p2 will rise.
Since there is an excess supply of
commodity 1, p1 will fall.
The slope of the budget constraints
is - p1/p2 so the budget constraints
will pivot about the endowment point
and become less steep.
Trade
A
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
B
xB ω1 OB
1
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
xB
2
Trade
A
x2
B
xB ω1 OB
1
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
Budget constraint for consumer B xB
2
Trade
A
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
Budget constraint for consumer B xB
2
Trade
A
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
So *A *B A B
x1 + x1 = ω1 + ω1 xB
2
Trade
A
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
and *A *B A B
x2 + x2 = ω2 + ω2 xB
2
First Fundamental Theorem of
Welfare Economics
Giventhat consumers’ preferences
are well-behaved, trading in perfectly
competitive markets implements a
Pareto-optimal allocation of the
economy’s endowment.
Second Fundamental Theorem of
Welfare Economics
Giventhat consumers’ preferences
are well-behaved, for any Pareto-
optimal allocation there are prices
and an allocation of the total
endowment that makes the Pareto-
optimal allocation implementable by
trading in competitive markets.
Second Fundamental Theorem
A
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The contract curve
xB
2
A
x2
*B B
xB x1 ω1 OB
1
*A *B
x2 x2
B
ω 2A ω2
OA *A A
x1 ω1 A
x1
xB
2
A Implemented by competitive
x2
trading from the endowment ω.
*B B
xB x1 ω1 OB
1
*A *B
x2 x2
B
ω 2A ω2
OA *A A
x1 ω1 A
x1
xB
2
A Can this allocation be implemented
x2
by competitive trading from ω?
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A Can this allocation be implemented
x2
by competitive trading from ω? No.
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A But this allocation is implemented
x2
by competitive trading from θ.
xB θ1
B
OB
1
θ2
A
θ2
B
OA
θ1
A A
x1
xB
2
Walras’ Law
Walras’Law is an identity; i.e. a
statement that is true for any
positive prices (p1,p2), whether these
are equilibrium prices or not.
Walras’ Law
Every consumer’s preferences are
well-behaved so, for any positive
prices (p1,p2), each consumer spends
all of his budget.
For consumer A:
*A *A A A
p1x1 + p 2x 2 = p1ω 1 + p 2ω 2
For consumer B:
p1x*1B + p 2x*2B = p1ω 1B + p 2ω 2B
Walras’ Law
p1x*1A + p 2x*2A = p1ω 1A + p 2ω 2A
p1x*1B + p 2x*2B = p1ω 1B + p 2ω 2B
Summing gives
p1 ( x*1A + x*1B ) + p 2 ( x*2A + x*2B )
= p1 ( ω 1A + ω 1B ) + p 2 ( ω 2B + ω 2B ).
Walras’ Law
p1 ( x*1A + x*1B ) + p 2 ( x*2A + x*2B )
A B B B
= p1 ( ω 1 + ω 1 ) + p 2 ( ω 2 + ω 2 ).
Rearranged,
*A *B A B
p1 ( x 1 + x 1 − ω 1 − ω 1 ) +
p 2 ( x*2A + x*2B − ω 2A − ω 2B ) = 0 .
That is, ...
Walras’ Law
*A
p 1 ( x1 + x1
*B
− ω1
A
− ω1 ) +
B
p 2 ( x *2A + x *2B − ω 2A − ω B2 )
= 0.
This says that the sum of the excess
demands across market is zero for
any positive prices p1 and p2 --
this is Walras’ Law.
Implications of Walras’ Law
So one implication of Walras’ Law for

a two-commodity exchange economy
is that if one market is in equilibrium
then the other market must also be in
equilibrium.
Implications of Walras’ Law
So a second implication of Walras’ Law

for a two-commodity exchange economy
is that an excess supply in one market
implies an excess demand in the other
market.

Final Topic Comp. Equilibrium

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Final Topic Comp. Equilibrium

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Chapter 11

 The total quantities available

 Edgeworth and Bowley devised a

 Allpoints in the box, including the

 All points in the box, including the

 DEFINITION: An allocation is Pareto-

 Where are the Pareto-improving

 Since each consumer can refuse to

B is strictly better Both A

 Where are all of the Pareto-optimal

 DEFINITION: The contract curve is

 But to which of the many allocations

 Rationaltrade should achieve a core

 Butwhich core allocation?

 Eachconsumer is a price-taker trying

 So given p1 and p2, consumer A’s net

 And, similarly, for consumer B …

 So given p1 and p2, consumer B’s net

 A Walrasian equilibrium is a vector

 So at the given prices p1 and p2 there

 Since there is an excess demand for

So one implication of Walras’ Law for

So a second implication of Walras’ Law

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The total quantities available

Edgeworth and Bowley devised a

Allpoints in the box, including the

All points in the box, including the

DEFINITION: An allocation is Pareto-

Where are the Pareto-improving

Since each consumer can refuse to

Where are all of the Pareto-optimal

DEFINITION: The contract curve is

But to which of the many allocations

Rationaltrade should achieve a core

Butwhich core allocation?

Eachconsumer is a price-taker trying

So given p1 and p2, consumer A’s net

And, similarly, for consumer B …

So given p1 and p2, consumer B’s net

A Walrasian equilibrium is a vector

So at the given prices p1 and p2 there

Since there is an excess demand for